Bringing Fed Funds Rate to Zero May Not Be the Best Idea

Excerpt from Raymond James Economist Dr. Scott Brown's latest economic commentary:

The Federal Open Market Committee began the current easing cycle in September 2007, when the Fed funds target rate was 5.25% – not especially high by historical standards. The Fed cut rates by 100 basis points by the end of last year and another 225 basis points by the spring. According to Fed Chairman Bernanke, “by way of historical comparison, this policy response stands out as exceptionally rapid and proactive.” However, financial instability increased in September and the FOMC cut by another 100 basis points in October (the October 8 move was an unprecedented coordinated cut with five other central banks). With inflation looking like a credible threat, some criticized the Fed’s rate cuts. However, in hindsight, the Fed’s action seems well-timed. Inflation did advance into the summer months, but has begun retreating, due largely to falling energy prices.

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Since October, the effective Fed funds rate has averaged 0.39% – well below the 1% target rate. This begs the question, would another 50 basis points taken off the Fed funds target rate qualify as an ease?

There may be some good reasons not to cut the target rate to zero. The Fed began paying interest on reserves in October (currently equal to the Fed funds target rate). Theoretically, the change was supposed to help set a floor on the actual funds rate. However, that hasn’t been the case. One factor, according to Fed Chairman Bernanke, is that some large suppliers of funds, such as Fannie Mae and Freddie Mac, are not eligible to receive interest on reserves and are willing to lend overnight federal funds at rates below the target.

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Still, the Fed is running out of room to cut. Nominal interest rates cannot fall below zero. However, as Fed Chairman Bernanke has indicated, “there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions.” One of these is quantitative easing.

Comments

[whidbey:]

Reminds one of the Japanese chase doesn't it? Will, no one ever believed that the FFRate was anything but a tell tail. The effective rate will tend to attract the target rate downward.

The implications of this are something else altogether. The Fed has ceased to have much effect on money and credit (if it ever had much), and we are now in the clutch of the consumption/demand path . It has already fallen 4-6% which means that aggregate demand in the US is down 2-4% and will decline further as consumers spend less and less and the economy declines.

The FFRate will end a zero and quant easing will start, followed by the Ice Age. This is the Japanese model and it is working here just as it has there.

2008 Dec 09 01:41 PM

[flow5:]

the academic community is full of sht & Keynes was wrong...the money supply can never be managed by any attempt to control the cost of credit

(1) Economists need to be able to understand the proper distinctions between means-of-payment money and liquid assets;

(2) know the difference between money creating institutions and financial intermediaries;

(3) recognize aggregate demand is measured by the flow of money - not nominal GDP;

(4) recognize that INTEREST RATES ARE THE PRICE OF LOAN-FUNDS, NOT THE PRICE OF MONEY,

(5)that the price of money is represented by the price level,

(6) does not confuse the supply of money with the supply of loan-funds

(7) that inflation is the most important factor determining interest rates operating as it does through the demand and the supply of loan-funds.

(8) and above all else recognize that even a temporary pegging of a series of federal funds rates over time forces the fed to abdicate its power to regulated properly the money supply

2008 Dec 10 12:00 PM